Unreal Options

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It’s a nice theory: In an uncertain world, investments in business projects create options for future action that have value just as financial options do. This simple analogy underlies a growing movement in strategy and finance that encourages companies to evaluate projects based not just on analyses of their likely future cash flows but on assessments of their real-options value. Investments that appear overly risky from a purely financial view, the argument goes, may be viable once you take into account the opportunities for future action they provide.

But there’s a problem with the theory, as any working manager would recognize. To gain adequate returns on a portfolio of options, whether financial or real, the portfolio has to be managed with rigorous rationality. As soon as an option no longer promises to provide future value, it must be abandoned. As Columbia Business School professor Rita Gunther McGrath put it in a 1999 article in the Academy of Management Review, “Options must be extinguished ruthlessly when they no longer promise high upside potential.” Yet business projects are not purely financial instruments that are coldly traded on open markets. They are, instead, complex organizational constructs that, once initiated, tend to take on lives of their own and become notoriously difficult to kill.

The tendency of companies to allow unpromising projects to drag on far too long is underscored in research by Isabelle Royer, a professor at the Université Paris Dauphine. She studied major product-development initiatives launched by two French companies, eyeglass maker Essilor and building materials producer Lafarge. Both companies continued to invest in the projects for many years after it became clear that they had little market potential.

Royer shows how members of project teams become imbued with a collective belief that their project will succeed, a conviction that over-whelms any individual skepticism. Ultimately, the team members enter into a state of “cognitive blindness,” as Royer puts it, actively ignoring signs that their efforts are doomed.

A similar social dynamic was revealed in a recent experiment conducted by Russell W. Coff and Michael Sacks of Emory University’s Goizueta Business School in Atlanta and Kevin J. Laverty from the University of Washington at Bothell, which showed that so-called social capital can distort funding decisions. The professors had business students make decisions about allocating additional funds to three hypothetical projects. From a purely rational real-options perspective, the decision should have been clear-cut: One of the projects offered higher returns than the other two. Yet the professors found that the more personal contact a decision maker had with a particular project’s proponent, the more likely he was to invest in it, even though it clearly did not warrant funding at the expense of the more-promising project. Although the researchers note that these findings are preliminary, they conclude that “social ties may encourage managers to escalate by investing further…in ill-fated projects” and they warn that “real options could lead to lower performance” if managers are encouraged to launch a flurry of projects on the assumption that they will be easy to kill down the road.

So when you make a funding decision, should you take into account an investment’s role in keeping your future options open? Of course. You shouldn’t foreclose a big opportunity by failing to make a modest additional outlay. But, on the other hand, you shouldn’t get carried away by the options analogy—it has serious flaws. Don’t make unreal assumptions about your real options.

A version of this article appeared in the December 2002 issue of Harvard Business Review.

Nicholas G. Carr is HBR’s editor-at-large. He edited The Digital Enterprise, a collection of HBR articles published by Harvard Business School Press in 2001, and has written for the Financial Times, Business 2.0, and the Industry Standard in addition to HBR. He can be reached at ncarr@hbsp.harvard.edu.

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